Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them.
Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation.
This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects.
The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

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De la lección

Activity-Based Costing (ABC). Relevant Costs

In Week 5 we will study the more advanced approaches to costing – activity-based costing (ABC) and relevant costs – that provide for the more accurate costing of products, projects, and divisions, and allow to reveal actual relationship between numbers and people.
We start with the analysis of ABC on an example of a small retail firm. Then we move on to the more detailed example of the use of ABC in manufacturing. Both examples will help us gain insight in the role of ABC in identifying ways to improve performance.
Finally, we analyze the idea of relevant costs and its application to managerial actions –make-or-buy decisions, product mix under capacity constraints, customer profit analysis. Of special attention will be the role of relevant and opportunity costs in valuation.

Impartido por:

Konstantin Kontor

Director and Professor of Finance and Strategy

Transcripción

Now, we are moving towards the next topic of this week, namely, the area of relevant costs. This is the key story in analyzing costs individually counting, and those are the key story in valuation. We will see on some examples how this is closely linked to the fundamental idea of the opportunity cost that is key in corporate finance. Therefore, by the end of this week, our understanding of costs will be put together. Not yet completed, but we will have a good idea why and how these costs crawl in in the evaluation process. So, what is the idea of relevant items? Relevant revenues, costs, the idea. Now, the story goes that we have a process of decision-making, and in this process, we have some stages. So, this is the decision-making process. So, what stages do we have here? We have information gathering. Then, from here, we move on to forecasting. Now, that is the key point, this is making choices among alternatives, because we have various forecasts. So, here we make choices. After having made choices, we have a commitment. From here, we go to implementation, and finally, we have evaluation and feedback. In reality, the process goes on and on. So, from feedback we may have some additional information gathering and we may change our forecasts, and that may influence our choices and so on and so forth. So, here the key story is that in making decisions, we are dealing with the future. The future means that we have expectations. So, that sounds perfectly familiar. When we talked about corporate finance, we said the future of the expectations, they were key there. Now, irrelevant items are the ones that are different with respect to different choices. So, irrelevant items are the ones that don't change if we change our choices, if we make different choices. So, that is the key story. So, we can put that relevant items, they differ with respect to future choices. to the future choices. So, we can see that here is the deep link of irrelevance to the idea of the opportunity costs. Although there are no opportunity revenues, but we know that opportunity cost sometimes they are some forgone revenues. So, from here, we have to move on and I will give you an example of relevance that shows to you, how where we take into account the relevance of certain number of items, that may fundamentally change our choice. So, we have a very simplified example of relevance. We will say that this is a company that's called Fancy Linen that makes some linen sets. The economics of this company is very simple. So, it makes at $20 a set. So, there's nothing fancy actually, just the name. Then, each month they sell 20,000 sets. So, this is their regular economics. Now, comes the company, let's say the chain of hotels that says, I make an order for two months, I will buy from you over 6,000 sets. So, this is the order at $12 per set. So, order looks like $12 per set and the overall amount is 6,000 pieces. We know that we work at the underutilized capacity level. So, we may easily and we actually can produce these pieces without any additional equipment, without equipment adjustment and so on and so forth. Now, and the question is, should we accept? This is a big question. Well, now we do not know the cost of the sets produced. We know that actually, it seems that the price is much lower than this one is. So, the initial temptation is to say no. But we have to analyze it further and see how that effects our decision. In order to do so, we have to take a look at our cost. So, this is the forecast, and this is total, and this is on a per unit basis. Let's try to see what we have here. So, we have regular things. This is sales of 400,000. Remember that was $20 a set and 20,000. Now, cost of goods sold now comes the cost structure is to 280 or 14. So, you can say, wait a minute, the cost is 14 and the hotel chain offers us just 12. So, we work below cost. But it's a little bit too early to make this final decision. Let's see what else we have here. So, we have gross margin of 120 or six dollars a piece, and we have marketing costs of 100,000 or five a piece. Therefore, our operating income is just $20,000 or one dollar per unit. Now, we see the cost of 14 here. But this cost consists of a fixed part and the variable part. So, we can say the cost variable nine plus fixed five. The total of 14. Like I said, the new order comes at a price that is below our cost. But, with respect to this order, some items are irrelevant. They wouldn't change regardless of whether we take the order or we decline the order. What are these cost components? First of all, this is fixed cost, which is five per share and marketing, because we don't need any additional marketing. The order will just comes, regardless of what happens if we take it. That is as you can see another five. Now, let's take a look at relevant revenues. So, relevant revenue is 6,000 pieces at $12, which is 72,000. We do incur variable costs on all these 6,000, and these variable costs are nine dollars. So, this is negative 54,000. So, if we accept the order, then the bottom line is positive $18,000. Why is that so? Because you can see that we have 12, which is the price and the variable cost is only nine. So, the difference is three and that is how we make money. So, you can see that the order comes at a price that is not only much lower than the regular selling price, but also is lower than the total cost. But, if we take into account the relevant items that are associated with this choice, we can see that the picture changes completely. So, this simplified example shows to you that the idea of relevance does play an important role in our analysis of costs. What follows? I will provide some other specific areas when the idea of relevance is not only important, but leads to decisions, that at first glance seem to be not so efficient.